evaluating & recommending bond & stable value funds for ...“consistently good advice in a...

“Consistently Good Advice in a Constantly Changing World”®

AEPG® Wealth Strategies 25 Independence Blvd

Warren, NJ 07059 908-757-5600

www.aepg.com

Evaluating & Recommending Bond & Stable Value Funds for 401k Plans Ahead of a

Rising Interest Rate Environment

Steven W. Kaye CFP® ChFC, CLU, CEBS, RHU, AAMS, CRC, AIF®

Aldo S. Vultaggio CFA, CPA, AIF®

April 2014


About the Presenters

AEPG Wealth StrategiesTM

Managing wealth for over 30 years as an independent fiduciary and registered investment advisor.

$800M in assets under management, with over 90 qualified retirement plans.

One of PLANADVISOR’s Top 100 Retirement Plan Advisors in 2014


President and Founder of AEPG Wealth Strategies

Aldo S. Vultaggio CFA, CPA, AIF®

Senior Portfolio Manager at AEPG Wealth Strategies

Evaluating & Recommending Bond & Stable Value Funds for 401k Plans Ahead of a Rising Interest Rate Environment

April 2014


Agenda

Challenges faced in the current environment.

Getting to know the plan and managing expectations

Stable Value fund decision and considerations.

Core Bond fund decision and considerations

Other bond fund menu options to consider

Bonds within Target-Date funds

Summary

Questions?


April 2014


Challenges Faced in the Current Environment

The problem is NOT that interest rates are going up!

The problem IS that participant perceptions and expectations are skewed!

Participant Perceptions and Expectations

“Bond funds can’t lose money.”

“Similar to the past, bond funds should provide me with 4 to 5% returns.”

Challenges faced by Plan Sponsors

Participant expectations need to be managed

Communication and education reduces ‘participant expectation shock’

Selecting bond funds that are in line with plan/participant objectives

Stable Value fund? Core Bond fund? Other bond fund menu options?


April 2014




April 2014

Fixed-Income Investment Options Offered in Plans Today

Fund Type offered in% of Plans General/Core Bond ~80% Stable Value/Guaranteed Investment Contract ~70%

Money Market ~60%

High Yield Bond/Treasury Bond ~50%

TIPS ~30%

International ~5% Source: Deloitte Annual 401k Benchmarking Survey 2012 (2012 data)




April 2014

Fixed-Income Investment Options Offered in Plans Today

Source: Vanguard, How America Saves Report 2013 (2012 data)


Getting to Know the Plan and Managing Expectations


April 2014

Culture of the company

Overall philosophy and mission of the retirement Plan.

Participant demographics and behaviors. Predominantly Gen Y, Gen X or Baby Boomers? Even balance?

Asset allocation to bond investments (Plan and Participant level)

Withdrawal activity

Bond fund investment objectives and priorities. Safety? Return? Retirement income? …all of the above?

What are participant expectations for their bond fund?

Fund Tracking-Error vs. Participant Expectation Tracking Error!!!


Stable Value Fund: Decisions


April 2014

Whether to use a Stable Value fund or a Money Market fund…

Pros Cons

Stable Value • Provide a much higher current yields (1.0% to 2.5%).

• Over long time periods, typically provide higher returns.

• Explicit principal protection offered by insurance company(s) to cover any market value below book value gap.

• Typically higher fees • Restrictions on the addition of new

investment options. • Increasingly constrained

investment guidelines. • Market value events tied to more

restrictive termination provisions.

Money Market

• Yields typically adjust quicker in the beginning phases of a rising (short-term) rate environment.

• Currently yielding zilch. • Typically underperform Stable

Value over long time periods. • No explicit principal protection in

the event of a ‘breaking the buck’’ scenario.


Stable Value Fund: Decisions


April 2014

What type of Stable Value fund to use…

Typical Profiles of… Relatively conservative Stable Value funds

(e.g.,CITs/Pooled Funds)

Relatively aggressive Stable Value funds

(e.g.,GICs/GA Funds) Crediting Rates (Yields) 1.0% to 1.5% 2.0% to 2.5%

Average Credit Quality (of underlying portfolios)

A+ to AA- AA to AA+

Average Duration (Years) 2.0 to 2.5 4.5 to 5.0

Market/Book Value Ratios (Average Ranges)

98% to 102% 95% to 105%

# of Wrap Contract Issuers Several One


Stable Value Fund: Considerations


April 2014

Creditworthiness of the wrap provider

Especially if using a single insurer GIC product

Plan Termination provisions

The existence (or lack thereof) “put” provisions.

Put provisions that extend beyond 12-months.

The potential for unexpected “market value adjustment events”

Necessary platform/fund changes.

Company/plan mergers.

Plan re-enrollment.

The ability to make future portfolio changes

Tighter investment guidelines set forth by wrap providers.


Stable Value Fund: Due Diligence Case Study


April 2014


Core Bond Fund: Decisions


April 2014

Whether to use a Core Bond Fund or not…

The decision should depend on the type of Stable Value fund used.

What type of Core Bond fund to use…

Only U.S. investment-grade bonds?

“Traditional” bond fund benchmarked to the Aggregate Bond Index

Expand the opportunity Set?

“Unconstrained” bond fund with specific risk and return objectives

“Flexible” bond fund

Hybrid Unconstrained/Flexible


Core Bond Fund: Considerations


April 2014

Interest rate risk is not the only risk to consider…

Interest Rate Risk

Equity Market Risk

Credit Risk “Return Surprise Risk”

Traditional bond fund

• High • Diversifies equity risk

• Low • Low

Unconstrained bond fund

• Low (?) • Not designed primarily to diversify equity risk.

• High • High

Flexible bond fund

• Medium • Diversifies equity risk, but muted

• Medium • Medium


Other Bond Fund Menu Options to Consider


April 2014

The Good News! There are many strategies to mitigate interest rate risk

Protect principal through insurance (e.g., Stable Value funds)

Diversify across all bond segments (e.g., Core bond funds)

…however, some may not be appropriate for 401k plans

Shorten duration (e.g., Short-Term bond funds)

Increase yield (e.g., High-Yield, Floating-Rate bond funds)

Protect from rising inflation (e.g., TIPS funds)

Holding bonds to maturity (e.g., Target-Maturity funds)

Diversify geographically (e.g., International bond funds)



April 2014

Considerations for each strategy…

Pros Cons Short-Term bonds funds

• Can reduce volatility

• Can reduce some principal risk

• Reduces yield income.

• May not keep up with inflation over time. • Does not provide much equity market risk

offset.

High-Yield bond funds

• Provides additional income

• Can provide higher returns.

• Can reduce some principal risk

• Higher volatility than investment grade bonds funds.

• High correlations with equities, particularly during declines..

Inflation-protected bond funds

• Potentially reduces principal risk (assuming inflation is rising!)

• Can diversify equity market risk during

flight to quality (Treasuries).

• Relatively high interest rate sensitivity of treasuries can offset inflation adjustment.

• Higher volatility than diversified bonds funds.




April 2014

Considerations for each strategy…

Pros Cons Target maturity bond funds

• Perceived benefit of principal returned at maturity.

• Can have higher volatility than diversified bond funds.

• Can be hard to administer in a 401k plan.

International bond funds

• Can reduce volatility (if currency hedged)

• Can reduce some principal risk since not directly tied to U.S. interest rates.

• Can diversify equity market risk during

flight to quality

• Currency effects can increase volatility if unhedged.

• Emerging markets bonds can have high

correlations with equities. • Relatively high expense ratios.




April 2014

The interesting case for international bond funds… but

Source: Vanguard





April 2014

The Bad News! Participants don’t know how to implement most of these strategies!

By themselves, some of these strategies can be risky!

Some of these strategies might not be good long term investments.

But there are some potential solutions:

Consider using fund options only with “participant balance limits.”

Consider broadly diversified (“all in one”) bonds funds.

Education and professional advice/management solutions.


Bonds within Target-Date funds

Target-Date funds will be the most widely used 401k investments soon!

Be aware of what is being done in bond allocations within them.

Plan Sponsors need to be aware of what is under the hood.

How is a target-date fund adjusting ahead of rising rates?

How will these adjustments affect risk! You may be surprised!


April 2014


Summary


April 2014

1) Participant perceptions and expectations of bonds funds are skewed

2) Understand the Plan, determine bond fund objectives, and manage expectations.

3) Strongly consider the importance (and potential issues) of using Stable Value funds.

4) Evaluate the Plan’s Core Bond fund, and consider available alternatives.

5) Be careful about recommending non-diversified (or single strategy) bond funds.

6) Consider recommending diversified strategy/asset-class bond funds.

7) Consider recommending professional advice/management solutions.

8) Be aware of the approach to bond allocations within the Plan’s target-date funds.


AEPG® Wealth Strategies 25 Independence Blvd

Warren, NJ 07059 908-757-5600

www.aepg.com

Top 100 Retirement Plan Advisors in 2014 ” “

by PLAN ADVISOR February 2014 www.aepg.com


[email protected] Aldo S. Vultaggio CFA, CPA, AIF®

[email protected]

Questions?

mailto:[email protected]

mailto:[email protected]


Disclosures

Important Disclosures: • The information expressed herein is for general and educational purposes only. This presentation is not a substitute

for personalized advice from AEPG Wealth Strategies and nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

• This information is current only as of the date on which it was sent. The statements and opinions expressed are,

however, subject to change without notice based on market and other conditions. • Definitions of the indices listed herein are available upon request. All investments carry a certain risk, and there is no

assurance that an investment will provide positive performance over any period of time. Investment decisions should always be made based on the investors specific financial needs, objectives, goals, time horizon, and risk tolerance. Please remember to contact AEPG Wealth Strategies if there are any changes in your personal or financial circumstances or investment objectives as these changes may impact our previous recommendations.

• AEPG is a federally registered investment advisor. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.

November 21, 2013


April 2014

evaluating & recommending bond & stable value funds for ...“consistently good advice in a...

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